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Michael Mendelson, principal and portfolio manager at AQR Capital
Management, recently answered our questions on strategies used with AQR Risk
Parity AQRIX. He talked about
the fund's equity exposure following the recent runup in stocks as well as the
ongoing events in Europe. He also discussed his take on interest rates and the
role leverage plays in the portfolio. Finally, Mendelson made note of the
inflation-hedging benefits found with commodities investments.

Has the rally in the stock market during the first quarter of 2012
caused you to rethink your exposure to equities versus the other major asset
classes (such as fixed income, inflation-linked, and credit) in which your fund
invests?Our target allocation is always long equities, and our
tactical views pushed us to take a larger-than-average position in them during
the first quarter. We tilt the portfolio toward assets that we think will
perform best based on shorter-term tactical views incorporating many signals
such as valuation, market momentum, and macroeconomic environment.

That said, our philosophy is to avoid concentration risk and maintain risk
diversification across the major asset classes globally. Tactical views can add
value, but they are subordinate to our long-term strategic goal of risk
diversification. One quarter, or even much longer periods, of good or bad
returns in any asset class does not change our strategic direction.

Your fund has the potential to invest in equity markets across the
globe. What regions look the most attractive to you now?Europe
looks attractive on the whole, and we like the core markets more than the
periphery. Eurozone large caps have been beaten down to the point where they
provide the best value among the developed markets. The macroeconomic prospects
for Europe also look better than current market prices suggest; for example, the
euro's depreciation during the past year could provide a boost to exports.
However, market momentum is still against Europe, so our overweightings have
been modest thus far.

We have been most cautious on commodity-sensitive Australia and Canada, as
these markets have negative momentum, yet valuations still seem elevated.

When do you expect interest rates will begin to rise? How are you
mitigating this risk?We start from a belief that the consensus
market judgment is pretty powerful, that positioning based on alternative
conclusions should be made with caution, and that our tactical tilts should be
in proportion to the strength of our conviction and the predictive quality of
our views. Therefore, we do not take a very strong stance on when or if rates
will start to rise. The yield curve already prices in rising rates in the coming
years, so the real question is whether we think rates will rise faster than
those bond prices imply.

Today, we believe that rates might rise a little faster than the changes
embedded into the slope of the yield curve. Bonds yields look low relative to
history, and an improving global economy suggests that prices are likely to
fall. Global bonds still have been performing well, and we're not looking to
fight the trend. Our underweighting in bonds is modest, but we are overall
bearish versus our strategic risk-parity benchmark.

How does the use of leverage affect the risk profile of your
fund?All risk-parity strategies use leverage because the
unleveraged risk-parity portfolio has very low risk and, therefore, not enough
return. In fact, on average an unleveraged risk-parity portfolio will have
annualized volatility of only 4%, too far below the 10% average volatility of a
more traditional portfolio of 60% stocks and 40% bonds. Leverage is employed in
all risk-parity strategies for the same reason: to elevate the risk level of the
risk-parity portfolio to something that approximates that of a traditional,
unleveraged, equity-concentrated portfolio. We think that risk parity is a more
efficient portfolio, and it will provide greater returns for the level of risk
taken in a long run. However, it cannot offer the same return as a traditional
portfolio if it carries less than half the risk.

We do not use leverage to take on outsized portfolio risk, but instead we use
leverage to allow us to manage a broadly diversified portfolio at a level of
risk similar to that of a traditional balanced portfolio. And leverage itself
carries some risk that must be managed. Risk-parity strategies are liquid, only
modestly leveraged, and invest mostly in futures, so managing that risk isn't
nearly as difficult as managing the concentration risk of the traditional
portfolio.

What is the role of commodities in your portfolio?We use
commodities to give investors exposure to inflation-sensitive assets that offer
good diversification benefits. During the past four decades, commodity futures
have had a near-zero correlation with equities while offering similar returns.
That diversification benefit is worth a meaningful place in the portfolio.

We have also researched the inflation sensitivity of various real-return
assets such as Treasury Inflation-Protected Securities, gold, REITs, and so on.
Looking at the performance of each of these assets during periods when inflation
was rising, or when inflation came in higher than predicted, we found that broad
exposure to commodity futures offered one of the best combinations of
inflation-hedging attributes and long-term returns. More importantly, we found
that potential inflation can be priced into assets very early, so
inflation-sensitive assets need to be part of a long-term allocation to gain the
full hedging benefits.

Although we don't know what future economic environments will be, many
potential ones include periods when stocks and bonds do poorly but assets that
tend to have some inflation sensitivity, such as commodities, do better. For
example, during much of the 1970s, U.S. equities and bonds had flat to negative
returns because of stagflation, while commodity futures performed remarkably
well as a result of supply shocks. Commodity exposure helps broaden the range of
economic environments in which the fund may do well.